Stock Optimism Clashes With Bond Pessimism

Bondholders and stockholders have vastly different expectations for the returns they seek, but more importantly, they have different reasons for investing. Bondholders only care that the company produces enough cash to pay its interest and ultimately repay its debt (or at least be in strong enough financial shape to have access to capital so it can repay its debt when it matures). Stockholders, on the other hand, can make money only if the company is able to grow its earnings and repay investors through increased dividends, share buybacks or through the implied value of the company.

Put simply, bondholders want companies not to strike out; stockholders want companies to hit home runs. This creates much different incentives. When an investor buys a bond, he will naturally be more negative and will try to figure out reasons the company may fail. If those risks are minimal, it is a safe investment. When an investor buys a stock, he will most likely take a more positive outlook and look for all of the reasons the company may be able to generate earnings growth.

Why does this matter? Because these divergent attitudes are causing the massive decoupling of stocks and bonds. Bondholders are very nervous about each company's ability to repay its obligations and are focusing on recovery value in the case of default. Meanwhile, equity investors continue to point out today's "value" by pointing out that earnings expectations have already been reduced. Bondholders are preparing for the worst, while stockholders are looking for the upside. The problem lies in how we assess "value," because we too often look at financial ratios that are no longer relevant in today's market.

The most common valuation metrics for a company's stock are price-to-earnings, price-to-sales, price-to-book, price-to-cash-flow and enterprise-value-to-EBITDA (in fact, while I type this I am listening to a promotional spot on CNBC telling me to look for stocks with high P/CF and low P/E ratios). When the ratio falls below historical levels or below competitors' ratios, we declare that the stock is cheap. That's fine if you are buying the stock vs. shorting its competitors' stock (or have a time machine and have figured out a way to short the historical value of its stock).

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Dorman has traded in the U.S. corporate bond market for more than severn years; for the last three years, he's worked as a high-yield and distressed corporate bond trader for Merrill Lynch. Prior to Merrill Lynch, Dorman worked as a credit analyst/trader on a distressed prop desk for Friedman Billings Ramsey and as an investment banker and capital markets analyst for Lehman Brothers.

Dorman graduated from Washington University in St. Louis in 2001 with a bachelor's degree in economics and finance and a minor in biology. Dorman played varsity baseball and football for Washington University.